Monday, July 16, 2012

Sustainable deficits and debts.

Sustainability is usually a term associated with environmental issues, but on the political right, government spending sustainability is what the elites and their supporters care about.I care about sustainability of all sorts, and while most of my work has been focused on environmental and commodity availability issues, I will now turn my attention to the concerns of the right leaning masses and elites.

Most right leaning politicians tell us that we must cut spending if we are to have a sustainable fiscal future.They warn that the current trajectory of government borrowing is unsustainable, and we need to cut spending, shrink the public sector and let the private sector take over. I figure there is no western country more appropriate at the moment to use as an example of what effect this would have than the United States.With deficit spending in the 8% of GDP range, and no meaningful measures implemented yet, it is a place where this is certainly a very hot topic of political argument.

Putting ideologically motivated political arguments aside, coming from both sides, ranging from humanitarian issues, to issues of “laissez faire” freedom ideology, I want to concentrate instead on a technical aspect of debt management in the current economy, as it is.When discussing debt and deficits, we should remember that the central federal government is not the only one engaged in accumulating it.There are the local governments, individuals and companies.This US debt, collectively ads up to $56 trillion and $3.8 trillion was paid in interest last year.Of that $3.8 trillion, only 225 billion dollars paid in interest was spent last year by the federal government, on a debt load of 15.8 trillion dollars accumulated so far[i].If we calculate the interest rate based on this fact, for federal government debt versus all other debt, the result is that while the federal government pays about 1.5% interest on debt currently, the rest of us pay about 9%.It is this collective payment of interest and its forward evolution going forward that I want to focus on.To do so, I assumed two different paths in US policy.One where 8% deficits will continue, until 2020, and one where it is cut drastically to a 3% average for the rest of the decade.

Assumptions:

In order to be able to calculate the effect of the two different paths, I have to keep certain factors constant.I realize that there are many arguments that are made especiallyin our left/right ideological battle over what effect either path would have on these factors, and I want people to know that I am aware of them.

Economic growth and inflation is the most important factor I will keep constant.For the past few years they added up to about 4%, so I will assume that this will be the average for the rest of the decade.I think that it is a very reasonable assumption to make, regardless of government policy, because it seems to be the actual potential for the US economy, given the global situation.I actually believe that the decade starting from 2020, will see economic growth slow further from the current 2% range, while I have no clue what inflation will do, because a lot depends on fiscal and monetary policy.I expressed my opinion and the reasons for having it on this issue in a previous article for those who are interested.

As far as interest rates go, I will also leave them in a holding pattern, which once again is not such an unrealistic proposal.The Federal Reserve will only move slightly, if at all in the next few years.The bond vigilantes will not find their way to the US by 2020, because they still have many stopovers to go through.Banks will not lend money any cheaper to individuals and companies, because the owners of capital are still spooked, so when they do lend money, they will ask for a risk premium.

The last constant I want to hold for my calculation is the total debt to GDP ratio.This once again, I think is not only convenient for the purposes of my forward projection to be made possible, but I think it is also another highly realistic scenario.Policymakers cannot allow credit to shrink, while the markets will be reluctant to allow it to grow too much, so a steady situation is plausible, even though in past decades, the ratio has been in a fast expansion mode.In this situation, total debt in US will be $77 trillion.

The results:

Assumption 1:8% per year deficits.

Assumption 2:3% per year deficits.

Year

GDP (4% nominal growth)

Assumption 1: 8%

Assumption 2: 3%

2012

$15.3 T

$16.0 T

$16.0 T

2013

$15.9 T

$17.3 T

$16.5 T

2014

$16.5 T

$18.6 T

$16.9 T

2015

$17.2 T

$20.0 T

$17.5 T

2016

$17.9 T

$21.4 T

$18.0 T

2017

$18.6 T

$22.9 T

$18.6 T

2018

$19.3 T

$24.4 T

$19.1 T

2019

$20.1 T

$26.0 T

$19.7 T

2020

$21.0 T

$27.7 T

$20.4 T

Interest 2020

N/A

$416 billion

$306 billion

As we can see from the chart, the prudent thing to do at first glance, assuming that fiscal policy would not affect growth, is to go to a 3% deficit rate.US government would pay over $100 billion less in interest and the debt to GDP ratio would once again go to under 100% by 2017.The question arises however, what will happen to the total interest paid in the economy in these two different scenarios, given the assumed constants that I already mentioned?

As we can see, when it comes to total interest paid within the economy, the lower federal deficit scenario will actually lead to a higher level of interest paid, by a significant amount ($550 billion per year).The percentage as a function of GDP will also rise, while in the high deficit scenario, it will go lower.

The effect on the economy in the 3% deficit scenario would be that it would starve both consumption and investment in non-banking and finance economic activity.In effect, it would most likely lead to another round of financial deleveraging, most likely worse than the one we witnessed in 2008, because the current slow pace of economic growth is leading to more vulnerable individuals, families and businesses.

The argument that the money collected in interest will be a boost to investment is increasingly a hollow one.The capital collected by those who collect interest will be re-invested, but not necessarily here.Capital always chases the place with the highest return, and the US is just not it.

I know that this would not work forever, because eventually the bond vigilantes would come knocking on the door, and at that point things can get rather nasty, as countries like Greece found out recently.The reality is however that in the absence of a plan to get back to the kind of growth needed to keep up with interest payments, the policy of cutting deficits before it is necessary to do so, is simply the wrong approach.

The right approach is to try to keep the economy afloat for the time needed to implement solutions meant to end global stagnation, and only once that is done, can cuts to government spending take place.Unless that is done, the only realistic effect cutting deficits will have is to choke the economy, as we can see now after years of cuts implemented in stagnated countries in Europe such as Greece and Spain.

I continue to believe that the main obstacle to global growth is sustainability.We need to get more value out of less, and that is the only way forward.It is a complex problem, which we are lacking the institutional capacity to deal with.But if we want to live is a complex society, we better culture up, and find the ability to deal with these complex problems, because in the absence of action soon, we will witness a readjustment to a more simple and brutal way of life, which will appropriately reflect our current cultural capacities, and we definitely don’t want that.

About Me

Author of book "Sustainable Trade". Book's central subject is a proposal for the elimination of all current bilateral, and multilateral trade agreements, in favor of a new tariff system meant to encourage sustainability. Double honors degree in History and Anthropology, and a B.A in Economics.